grorrp
COMMENTARY
57
DECEMBER 1998
RET'ISTTING
DIRECTED BROI(ERAGE:
STTLL
NCD
FREE
LUNGH
A
7996 Plexus
study
of
one
clrent's drrected andnon-dtrected
trades
concluded
that whrle drrectedtrades
had
lower
tmpact
and
commisslon
cosrs,trmrng
and opporlunity
costs
outwelghed the
sav-
ings.
More
importanLly,
drrected
lradlng
discourageslradrng
rn
raptdlymovrng
sltuattons.
leadtng
to
significant underperformancerelatlve
to
non-dtrected
trades.
Thls
follow-up
study
of more
clients
and
a longer time
frame,comes to slmrlar conclusrons
that
[7J
dlrected
trades
show
no
cost
advantage
when
adjusted
for
expected
costs, ancl
[2J
rndrrectly emphaslzrng
lower
costtrades leads
to lower
returns than reallzedthrouqh non-dlrected
trades.
many,
we
suspect.
"...CgptUring
3(
Of
COtn-
broker at
a
time.Sponsors
who
cap-
mission
cost
the
direct-
Sincethe
trader's
ture
commissions
iobisto
control
forfundadministra-
ing
sponsors
10.3(of
,
'informationflow
tion
implicitly
be- perform&nce..."
to
brokers
in
a
lievethat
a
higher
waythat
secures
Howmany
sponsors
would
agree that
higher
commissionscan
lead
tocommission
buys nothing
of
value.Consequently.
rnanagers
continue
to
feel
pressure
to
direct
commissions
to designated
brokers
for
sponsor
use.
The burden
ofproof
that
commissions
can
be
a
tool,
not
just
a
cost,
has
fallen
on
the
manager.
Managers
in-
tuit
that direction alfects
investment
perfomance,
but
seldom
possess
suf-
ficient
information
to
demonstrate
that
they
are
usingcommissions
ef-
fectively.Measuring the
true
cost
of
direction
requires
looking
beyond
the
obviouscosts
of
commissions and
directim-
pact.It
needs
to
include
timing
costs
incurred
while
a directing
broker
seeks
or
awaits
liquidity,
as
well
as
foregone returns
when
liquidity
fails
to
develop.
These costs capture
the
effects
of
disruptions
to
a
manager's
normal
execution
strategies.While
proponents
of direction
argue
that
di-
rection
should not
disrupt
a
manager's
process,
we
show that differences re-
sulting from
the sequencing
of
trades
can
be significant.
NYSE
Rule
122
specifically
prohibits
a
member
firm from
trading
a
stock
with
best
execution
for
all
accounts,seqllenc-
ing
of
directed trades
naturally
results.
When
prices
move rapidly,
timing
becomes
a
priority.
Accounts
that
di-
rect trades
to
specific
firms
lose
timing
advantage
whrle
recapturing
cornrnis-
sions.
How
are
we
to
assure
this
tradeoff
is
in
the
client's
best
interest?
The
1996
Plexus study
of
a
growth
manager's
directedtrading
showed
that:
o
Directed
trades cost
more
than
non-directed trades;
1
I
2
bp
as
con-trasted
to
83 bp.
o
The
ratio ofcosts
to
expected costswere more
unfavorablefordirected
trades:
560
o
over
expectationcom-paredto
40o
over
expectation.
o
Serious
problemsdeveloped
in
ex-
perienced
net
returns,-3.l9oA
for
directed
trades vs.
+0.470%
for non-
directed.
As
a
result,directed
ac-
counts realized
lower
returns
for
traded
shares.
Plexus
now
has
r"-rp
to ninequarters
of
directed
trading
data
for
eight clients.
This
sample
provides
both a
deeper
poolfor comparison
and
a
goodcross-
section
over
time.
The
sample in-
cludes
both
large-cap
and
small-cap
as
well
as
value and
growth
strate-
gies.
ln
1Q98,
the
sample included$48
bil.
of
decisions
of
which
22%represented
directed
decisions.
Because
the
analysis covered
a
broaderrange
of investment
styles, the
effects
of
delays were
reduced. Tim-
ing
costs
fordirected
trades
fell,
com-
paringmore favorably
to
the
non-di-
rected
trades.
However,
the
bench-mark
costs
for
directed trades also
fell.
As
a
result,
directed trades
lagged
their
benchmark
by
400%,
compared
to
8%
for
non-directed
trades.
An
interesting
finding
wasthat
im-
pactand commissions converged
for
the
two
groups
of
trades.
Directedimpact
*
commission
costsrose
from
25
to
2l
bp,
while
non-directed
costs
fell
from
39
to
33
bp. This
is
consis-
tent
with
the
steady
drop
in
average
commission
ratesdue
to
increased
use
of
Proprietary Trading
Systems
such
as
lnstinet
and ITG/Posit.
The
ques-
tion
appears
to
be
no
longer the
levelof
commissions;
rather
how
the
com-missions
are
used.
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